Monday, April 09, 2007

The Fed has been discussing whether to adopt an explicit inflation target,
something Ben Bernanke favors, and this has brought about an active debate within
the Fed and elsewhere about the virtues of inflation targeting generally, and
explicit inflation targeting in particular. With explicit inflation targeting
the central bank announces a target inflation range, the measure of inflation it
will use to assess price pressures, how much time it will allow to bring
inflation within the target range, and so on. As noted, presently the U.S. does
not announce its target, but many other central banks do.

One argument for explicit inflation targeting is that it helps to anchor
inflation expectations, more so than with an implicit target like the U.S. uses. However, Alan Greenspan
and others argue that there is also a cost to committing to an inflation target, loss of flexibility when large
unexpected events hit the economy. Since the Fed has been able to control
inflation without an explicit target, they argue there is little to be gained in
terms of anchoring expectations from moving to explicit targets.

There are two responses to this. First, as Bernanke and others have argued,
flexibility can be built into a targeting regime so the costs are not as large
as claimed.

But what about the benefits? The second response is that the benefits may not
be as small as many have argued. This paper exploits cross-countries differences
in whether inflation targets are explicitly announced to examine whether
explicit targets lead to more firmly anchored inflation expectations. The paper finds
evidence that explicit inflation targeting does help to to anchor expectations,
i.e. that there are benefits to announcing a target, even for a country like the
U.S. with a strong and credible inflation fighting record over the last few
decades:

Inflation Targeting and the Anchoring of Inflation Expectations
in the Western Hemisphere, by Refet S. Gürkaynak, Andrew T. Levin, Andrew N.
Marder, and Eric T. Swanson, FRBSF Economic Review 2007: [This article is reprinted from the conference volume
Series on Central Banking, Analysis, and Economic Policies X: Monetary
Policy under Inflation Targeting, eds. Frederic Mishkin and Klaus
Schmidt-Hebbel. Santiago, Chile: Central Bank of Chile, 2007.] Abstract We investigate the extent to which long-run inflation
expectations are well anchored in three Western Hemisphere countries—Canada, Chile, and the United States—using a high-frequency
event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation—the difference
between forward rates on nominal and inflation-indexed bonds—as an indicator of financial market perceptions of
inflation risk and the expected level of inflation at long horizons. For the United States, we find that far-ahead forward inflation
compensation has reacted significantly to macroeconomic data releases, suggesting that long-run inflation expectations
have not been completely anchored. In contrast, the Canadian inflation compensation data have exhibited significantly less
sensitivity to Canadian and U.S. macroeconomic news, suggesting that inflation targeting in Canada has helped to anchor long-run
inflation expectations in that country. Finally, while the requisite data for Chile are available for only a limited
sample period (2002–2005), our results are consistent with the hypothesis that inflation targeting in Chile has helped anchor long-run
inflation expectations in that country as well.

1. Introduction Many central banks have adopted a formal
inflation-targeting framework based on the belief and the theoretical
predictions that an explicit and clearly communicated numerical objective for
the level of inflation over a specified period would, in itself, be a strong
communication device that would help anchor long-term inflation expectations.[1]
Empirically verifying the success of inflation-targeting regimes in this
dimension has been difficult, however, as survey data on long-term inflation
expectations tend to be of limited availability and low frequency.[2]

In this paper, we use daily bond yield data for Canada, Chile, and
the United States to investigate whether long-term inflation
expectations in these countries are anchored, essentially extending the
analysis of Gürkaynak, Sack, and Swanson (2005) and Gürkaynak, Levin,
and Swanson (2006) to examine comparable data for Canada and Chile. Of
these three countries, Canada and Chile have been formal inflation
targeters throughout much of the 1990s and 2000s, while the United
States has not had an explicit numerical inflation objective. We test
the success of inflation targeting in anchoring long-term inflation
expectations by comparing the behavior of long-term nominal and indexed
bond yields across these three countries in response to important
economic developments. Forward inflation compensation—defined as the
difference between forward rates on nominal and inflation-indexed
bonds—provides us with a high-frequency measure of the compensation
that investors require to cover the expected level of inflation, as
well as the risks associated with inflation, at a given horizon. If
far-ahead forward inflation compensation is relatively insensitive to
incoming economic news, then one could reasonably infer that financial
market participants have fairly stable views regarding the distribution
of long-term inflation outcomes. This is precisely the outcome one
would hope to observe in the presence of an explicit and credible
inflation target.

The daily frequency of our bond yield data, together with the frequent
release of important macroeconomic statistics and monetary policy announcements,
provides a large event-study data set for our analysis. This holds even for
samples that span only a few years—the period for which we have
inflation-indexed bond data for the United States and long-term nominal bond
data for Chile. Thus, in contrast to previous empirical work using quarterly or
even semiannual data, we are able to bring to bear thousands of daily
observations of the response of long-term bond yields to major economic news
releases in Canada, Chile, and the United States.

For the United States, we find that far-ahead forward nominal interest rates
and inflation compensation have responded significantly and systematically to a
wide variety of macroeconomic data releases and monetary policy announcements.

These responses are all consistent with a model in which the private sector’s
view of the central bank’s long-run inflation objective is not strongly
anchored, as we show. In Canada, far-ahead forward nominal interest rates and
inflation compensation have displayed much less sensitivity to either domestic
or foreign economic news. Thus, the anchoring of long-run inflation expectations
in Canada appears to have been stronger than in the United States. Finally, the
data for Chile are more limited in terms of the sample period, the depth and
breadth of fixed income markets, and the availability of domestic macroeconomic
data releases. Despite these limitations, we do not find significant responses
of far-ahead inflation compensation in Chile with respect to domestic or foreign
macroeconomic news.3

...

6. Conclusions As in Gürkaynak, Sack, and Swanson (2005) and Gürkaynak,
Levin, and Swanson (2006), we find that U.S. longterm nominal interest rates and
inflation compensation are excessively sensitive to macroeconomic data releases
and monetary policy announcements. In contrast, we find that long-term nominal
interest rates and inflation compensation in Canada display much less
sensitivity to economic news, while the unconditional volatility of these series
over the past decade has been markedly lower than in the United States. These
results are consistent with the findings of Gürkaynak, Levin, and Swanson (2006)
for Sweden and the United Kingdom, two countries that have also maintained
explicit inflation targets in recent years.

In the case of Chile, the available sample period is fairly short and only a
limited set of macroeconomic news releases are readily available. Nevertheless,
our regression analysis does not indicate any excess sensitivity of far-ahead
forward interest rates and inflation compensation, which is consistent with the
hypothesis that inflation targeting in Chile has been reasonably successful in
anchoring long-run inflation expectations. ... While not entirely conclusive,
these results suggest that the presence of a transparent and credible inflation
objective can play an important role in anchoring long-run inflation
expectations in both emerging market economies and industrialized countries.

Our findings suggest that the potential welfare gains from reduced bond
market volatility would be an important subject for future research. Although we
have not demonstrated any such welfare gains in this paper, existing
macroeconomic and finance theory identifies several possibilities: for example,
less persistent deviations of inflation from target in the short and medium run
as a result of firmer anchoring of expectations at the long end (Woodford 2003);
a greater ability of the central bank to control inflation in the short and
medium run (Woodford 2003); less volatile long-term nominal interest rates and
lower risk premiums on nominal rates, which would improve the efficiency of
investment decisions (Ingersoll and Ross 1992); and a reduced chance of either a
1970s-style expectations trap for inflation (Albanesi, Chari, and Christiano
2003) or an imperfect-information-driven inflation scare (Orphanides and
Williams 2005). To the extent that these benefits are important in practice as
well as in principle, adopting a more explicit inflation objective could improve
U.S. economic performance and U.S. monetary policy even beyond the successes of
the past 20 years.

2. For an analysis using semiannual survey data on long-run inflation
expectations in the 1990s and early 2000s for a panel of countries, see Levin
and Piger (2004).

3. Ertürk and Özlale (2005) obtain a similar finding of anchored expectations
for Chile using a GARCH specification on monthly Chilean data.

This won't settle the issue, but it does add to the weight of evidence in
favor of explicit inflation targets. For more on inflation targeting, see David Altig at macroblog who discusses whether U.S. expectations are presently losing their anchor.

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Explicit Inflation Targets and Anchored Expectations

The Fed has been discussing whether to adopt an explicit inflation target,
something Ben Bernanke favors, and this has brought about an active debate within
the Fed and elsewhere about the virtues of inflation targeting generally, and
explicit inflation targeting in particular. With explicit inflation targeting
the central bank announces a target inflation range, the measure of inflation it
will use to assess price pressures, how much time it will allow to bring
inflation within the target range, and so on. As noted, presently the U.S. does
not announce its target, but many other central banks do.

One argument for explicit inflation targeting is that it helps to anchor
inflation expectations, more so than with an implicit target like the U.S. uses. However, Alan Greenspan
and others argue that there is also a cost to committing to an inflation target, loss of flexibility when large
unexpected events hit the economy. Since the Fed has been able to control
inflation without an explicit target, they argue there is little to be gained in
terms of anchoring expectations from moving to explicit targets.

There are two responses to this. First, as Bernanke and others have argued,
flexibility can be built into a targeting regime so the costs are not as large
as claimed.

But what about the benefits? The second response is that the benefits may not
be as small as many have argued. This paper exploits cross-countries differences
in whether inflation targets are explicitly announced to examine whether
explicit targets lead to more firmly anchored inflation expectations. The paper finds
evidence that explicit inflation targeting does help to to anchor expectations,
i.e. that there are benefits to announcing a target, even for a country like the
U.S. with a strong and credible inflation fighting record over the last few
decades:

Inflation Targeting and the Anchoring of Inflation Expectations
in the Western Hemisphere, by Refet S. Gürkaynak, Andrew T. Levin, Andrew N.
Marder, and Eric T. Swanson, FRBSF Economic Review 2007: [This article is reprinted from the conference volume
Series on Central Banking, Analysis, and Economic Policies X: Monetary
Policy under Inflation Targeting, eds. Frederic Mishkin and Klaus
Schmidt-Hebbel. Santiago, Chile: Central Bank of Chile, 2007.] Abstract We investigate the extent to which long-run inflation
expectations are well anchored in three Western Hemisphere countries—Canada, Chile, and the United States—using a high-frequency
event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation—the difference
between forward rates on nominal and inflation-indexed bonds—as an indicator of financial market perceptions of
inflation risk and the expected level of inflation at long horizons. For the United States, we find that far-ahead forward inflation
compensation has reacted significantly to macroeconomic data releases, suggesting that long-run inflation expectations
have not been completely anchored. In contrast, the Canadian inflation compensation data have exhibited significantly less
sensitivity to Canadian and U.S. macroeconomic news, suggesting that inflation targeting in Canada has helped to anchor long-run
inflation expectations in that country. Finally, while the requisite data for Chile are available for only a limited
sample period (2002–2005), our results are consistent with the hypothesis that inflation targeting in Chile has helped anchor long-run
inflation expectations in that country as well.